At its core, the EAD as per the SA-CCR is comprised of two components: the replacement cost (RC) and potential future exposure (PFE). Mathematically, the calculation is expressed as follows:
where α is a constant scaling factor set at 1.4 (consistent with the IMM).
Replacement cost (RC):
The RC component reflects the immediate loss that would occur if the counterparty were to default and the trades closed out (i.e., the current exposure). In simple terms, the RC is calculated as the total mark-to-market (MtM) of the derivative trades at the netting set level, less collateral. The RC is floored at zero. However, the exact calculation depends on whether the trade is subject to a margin agreement related to the exchange of a variation margin.
Potential future exposure (PFE):
The PFE component intends to capture the potential increase in the derivative exposure in the future (e.g., due to fluctuations in market factors) and consists of two elements:
- A multiplier that allows for the recognition of excess collateral and negative MtM values.
- An aggregate add-on that represents the sum of five asset class-level add-ons.
While the RC is computed at the netting set level, the PFE add-ons are more computationally intensive and are calculated for each regulatory asset class within a given netting set and subsequently aggregated to the total PFE add-on for the same netting set. Each asset class is in turn subdivided into different hedging sets, whereby the latter represent groups of transactions within or across which full or partial offsetting (i.e., hedging) is permitted.
The add-on calculations for each of the regulatory asset classes follow distinct rules, summarised in the following table:
Interest rate (IR)
Hedging sets are defined per currency (e.g., EUR, USD, JPY, etc.) and further subdivided per maturity bucket:
- Maturity < 1 year.
- 1 year ≤ Maturity ≤ 5 years.
- Maturity > 5 years.
Full offsetting between long and short positions is allowed within the same hedging set and maturity bucket, while only partial offsetting is recognised across maturity buckets.
Foreign exchange (FX)
Hedging sets are defined per currency pair (e.g., FX derivatives referencing EUR/USD and USD/EUR belong to the same hedging set). Full offsetting between long and short positions is allowed for the same currency pair, while offsetting across different currency pairs is not recognised.
Credit spread (CS)
Hedging sets are defined per entity (or index) referenced by the credit derivative. Full offsetting between long and short positions is allowed for the same entity (or index), while only partial offsetting is recognised across different entities (or indices).
Similar to the CS asset class, hedging sets are defined per entity (or index) referenced by the equity derivative. Full offsetting between long and short positions is allowed for the same entity (or index), while only partial offsetting is recognised across different entities (or indices).
Hedging sets are defined per commodity category and further subdivided per commodity type (the latter must be defined by the institution such that basis risk is minimized):
- Energy (further specified as WTI, Brent, LNG, etc.).
- Metals (further specified as gold, silver, copper, etc.).
- Agriculture (further specified as corn, soyabeans, wheat, etc.).
Full offsetting between long and short positions is allowed for the same commodity type, while only partial offsetting is recognised across different commodity types within the same commodity category. Offsetting between commodity categories is not permitted.
While allocating a vanilla derivative to a given asset class is generally straightforward, this may not be the case for more complex/hybrid trades that embed multiple risk drivers. According to the regulation, the mapping should be based on the primary risk driver of each derivative transaction, if available (e.g., the primary risk driver of an equity option is the underlying equity). All material risk drivers should be identified if there is no single risk driver. Beyond this generic requirement, neither the Basel nor the CRR2 standards provide further guidance.
As a result, in December 2019, the EBA published a final draft RTS “on mapping of derivative transactions to risk categories” (EBA-RTS-2019-02), outlining a three-pronged method:
- Purely qualitative approach: The first approach is suitable for “simple” derivatives that have one clear risk driver, whereby the latter can be determined qualitatively (i.e., no computation and comparison of sensitivities is required).
- Qualitative & quantitative approach: When it is impossible to easily determine a single risk driver via the first approach, the second approach requires the institution to identify all possible risk drivers and calculate the derivative’s sensitivity to each. Ultimately, this analysis leads to mapping the derivative to one or more risk categories.
- Fallback approach: When it is impossible to perform the mapping based on the first two approaches, the fallback approach requires the allocation of the derivative to all the risk categories corresponding to all the risk drivers (regardless of materiality) of the trade.